Market Thinking

making sense of the narrative

The Real Problem with Bonds

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As the title implies, this short series of posts addresses four important and inter-related problems with Wealth Management and by extension Asset Management and in conclusion offers a Solution.

The article in the FT (Global bond markets on course for worst year since 1999) today is a good place to start off this short series of Post Christmas Posts, as it highlights the emerging existential crisis for Bond markets – their managers and sales people as well as their actual underlying clients. With still very low nominal yields thanks to a decade of financial repression and with the general price level rising, regardless of whether it is reflation or inflation, temporary or otherwise, the ‘Real Problem’ with Bonds is that not only do they no longer offer the prospect of anything approaching a ‘real’, as in inflation adjusted, return on investment, but also that they no longer offer the low volatility or lack of correlation that made them suitable to stabilise balanced investment portfolios.

Real yields have been a problem for a long time

The fact that bonds offer negative real yields is hardly a new or unique observation, indeed it is one that has been made pretty consistently for at least the last decade, as the unprecedented response to the Global Financial Crisis ushered in the era of QE and in many case negative nominal yields as well. However, there is a bigger issue, the real problem is not really to do with low or even negative expected returns, it is that, over the last decade, the response of the Bond Market ‘industry’ under QE has been such that bonds have now ceased to be fit for purpose as a long term investment vehicle.

In fact the problem of negative real yields goes back far beyond the GFC and indeed one might go as far as to say that the Global Financial Crisis was itself created by the earlier attempt at a ‘solution’ to this problem of low yields, in the form of the whole Credit Derivative and Credit Default Swap market. The attraction of the CDS market to Bond fund managers was that, thanks to the use of leverage, it appeared to offer a higher return and that thanks to the ‘off market’ nature of the pricing, it also appeared to be highly stable. As a result, enormous amounts of pension fund and insurance company capital flowed into products that offered the illusion of high return for low risk while simultaneously ticking all the right boxes created by regulators in the wake of the Dot-Com crash. An approach of ‘it only matters if we can measure it’ meant that the two things that could be monitored – volatility and benchmark correlation – were all that were counted and thus the only things that, well, counted. Leverage and (il)liquidity, the actual source of much of the returns, were both ignored. Until of course it all went into reverse in 2008 and the market went from ‘no offer’ to ‘no bid’. CDS’s were stable, right up to the moment you needed them to be. The solution created a, bigger, problem.

Regulators and Consultants have created a ‘teach to the test’ culture where returns are generated by taking risks that are not monitored

Government intervention in bonds has delivered terrible Capital Allocation

Of course, post the GFC, the solution was ‘more of the same’ substituting other forms of illiquid instruments like Private Equity, Private Credit and Property. Meanwhile, the intervention in the form of QE meant that the world inverted and bonds became a source of Capital gain and equities a source of (dividend) income, even as the same regulators drove long term money further out of equities and into ‘low risk’ bonds (and alternatives). Here the risk for long term investors was still defined by regulators with reference to the terminology of ‘risk free’ from the CAPM model and from so called Value at Risk models meant to monitor short term trading volatility. This focus on risk as only being about volatility and benchmarks helped sustain the Bond bull market, but was terrible for capital allocation in the wider economy. For example, the fact that the actuarial calculations based on lower bond yields meant that pension funds were now ‘underfunded’, required capital that might otherwise have been returned as dividends, or more importantly gone into productive investment, to instead go into pension funds to buy yet more low yielding bonds. It also meant that many, younger, companies, without large pension fund liabilities, found themselves able to issue ultra cheap corporate debt and use it to buy back their own shares. This was of course particularly true in US Tech space, where tax arbitrage was also a factor and where many of the shares bought back were in fact simply cancelling the extremely generous options granted to insiders and where the share price performance for which they were being rewarded was more a function of those buybacks than anything else. Meanwhile, in the old economy, the increase in pension costs was a major factor in offshoring a lot of manufacturing and driving the latter phase of globalisation.

As with much in investment, a major problem for Bonds is the assumption that the benchmark is an appropriate Portfolio

The Industry developed into a Bar-bell of quasi cash and Junk

One consequence of all this was the growth in the “high Yield’ space, previously (and perhaps more accurately) described as ‘junk bonds’. In many instances, the amount of money in ‘low risk bonds’ as an asset class looking for returns meant that, what might previously be seen as high risk equity investments, with the appropriate levels of due diligence, diversification and so on, instead became funded through concentrated holdings in ‘low risk bond’ portfolios on the curious assumption that somehow, even the highest risk bond is less risky than equity. In particular, it enabled a huge transfer of savings capital to the US alternative energy space, as the fracking boom delivered ‘cheap’ oil and gas to the US, albeit in reality just heavily subsidised by (largely unwitting) pension fund savers.

Latterly this framework has also helped drive capital to situations like the offshore Bonds of Evergrande, a company whose stock that would have been categorised as ‘high risk value’ (to put it politely) long before the ‘surprise’ default. Part of the problem with all of this is that the technicalities of the High Yield indices are such that the biggest weighting in the index is given to the company with the most debt. From a portfolio construction basis, this is even more absurd than the Equity practice of giving a company with $100bn of market cap 10x the weighting of one with a $10bn market cap, but this is not the fault of the index provider. Rather it is the fault of a system that seeks to minimise ‘risk’ by defining this as minimising deviation from a benchmark, without considering whether the benchmark is an appropriate portfolio for the end investor.

Thus, the bond component of many portfolios has tended to end up as a bar-bell of ultra short dated bonds and high yield bonds, which are only ‘risk free’ to the extent that their default is limited by the existence of equity to take the full loss, meaning they are in fact far riskier than an equity component that has no exposure to such bad businesses. Looking forward and with the prospect of tighter monetary policy and the certainty of higher price levels, we now find ourselves, after a decade of government intervention and misplaced risk management, asking what now is the role, if any, for bonds in long term investment portfolios?

Bonds are not alone in no longer being fit for purpose. In the next article we will look at the problems offered by Passive Equities and their benchmarks.

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